The First Step in Restructuring the US Electric Industry

A. H. Barnett

American University of Sharjah, Auburn University

abarnett@business.auburn.edu

Keith A. Reutter

Nathan Associates

kreutter@nathaninc.com

Henry Thompson

Auburn University

thomph1@auburn.edu

Abstract.� The electric industry lobbied for its first step in restructuring, from local franchises to regulated state monopolies during the early 1900s.� The present paper examines this restructuring with an empirical model that includes the introduction of natural gas and steam turbine generators.� The restructuring resulted in fewer firms, higher costs, and higher prices, consistent with increased monopoly power and captured regulators.�

�

Introduction

Electric industry restructuring is underway, if with halts and sputters.� There is interstate wholesale competition and tentative steps toward retail competition.� Congress has introduced national bills and the Clinton administration had a tentative proposal, but the Bush administration has taken no steps.� As restructuring evolves, disagreement over its virtues are bound to persist.� Several studies speculate about how a �deregulated� market might function, some pointing to market complexities that raise doubts about applying straightforward economics principles.� Restructuring is an economic, legal, and political issue.

There is perspective gained by looking back at the first restructuring of the industry, a move from its early days of local competition to regulated state monopolies.� In its infancy, the US electric industry was a collection of competitive local franchises.� Shortly after the turn of the 20^th century and following industry lobbying, individual states began to establish regulated monopolies.� By the 1930s, the industry was transformed.� The present paper uses an empirical model to assess the impact of this restructuring on industry conduct and performance.

1.� A Competitive Electric Industry

Commercial generation began in 1882 with plants opening in New York City and Wisconsin. �By 1890, there were a thousand generating facilities producing direct current (DC).� The cost of transmitting DC much beyond a mile was prohibitive, limiting the geographic area served by a single generator.

Since each city had an independent franchising authority, electric firms trying to expand their areas found multiple negotiations and differing fees both costly and burdensome.� As relief, the industry led by Samuel Insull of Chicago Commonwealth Edison advocated state regulation.� McDonald (1962) points out that Insull led members of the National Electric Light Association, later Edison Electric Institute, in a call for state regulation.�

The first state to implement a public service commission (PSC) was Massachusetts in 1889, followed by Virginia in 1902.� By 1912, there were 18 states with PSCs.� The number of PSCs then increased dramatically, reaching 38 by 1922 and becoming almost universal by the 1930s as summarized in Table 1.

�� Table 1.� Dates of State Regulatory Commissions

Year�� State��

1889�� MA��

1902�� VA

1907�� NY WI��

1908�� VT

1909�� MI��

1910�� MD

1911�� CA CT KS NH NJ NV OH OR WA

1912�� AZ RI

1913�� CO HI ID IL IN MO MT NC OK WV

1914�� ME PA��

1915�� AL SC WY

1917�� UT��

1919�� ND TN

1920�� GA��

1921�� LA

1934�� KY��

1935�� AR

1941�� NM��

1949�� DE

1951�� FL��

1956�� AK MS

1972�� NE��

1975�� SD MN TX

�� Source: NARUC Yearbook of Regulatory Agencies 1991-1992

PSCs regulated prices within state boundaries but Clemens (1950) points to the interstate pricing issue made clear by the Attleboro case of 1927.� Narragensett Electric in Rhode Island sold a small amount of electricity to Attleboro Steam and Electric in Massachusetts.� The Rhode Island Commission considered the low rate a burden on Rhode Island consumers and ordered a higher rate.� Misery loves company.� The Supreme Court, however, ruled that the mandated rate placed an unconstitutional burden on interstate commerce.� The US Congress subsequently amended the 1920 Federal Water Power Act with the Federal Power Act of 1935 granting the Federal Power Commission jurisdiction over interstate wholesale rates.

2.� Restructuring, 1907-1932

Table 2 presents some historical data, including the real price of electricity P_e calculated as average revenue per kilowatt hour (kWh) in 1932 dollars.� The raw data from the Census of the Electric Power and Light Industry includes industry total revenue TR, quantity of output Q, the number of firms F, and the horsepower of different types of generation.� The price dropped dramatically between 1907 and 1917. �By 1927, however, 34 states had regulated monopolies and the price of electricity began to rise. Similarly, the number of firms peaked in 1917 but with the increased prevalence of state regulation declined 48% by 1932.� Output increased during this period, more than doubling from 1912 to 1917 and again from 1922 to 1927, as the number of customers grew exponentially.

Table 2.� Evolution of the Early Electric Industry

�� 1907 �� 1912 1917 1922 1927 1932

electricity price, P_e�� $0.45�� $0.39�� $0.22�� $0.21�� $0.20�� $0.27

number of firms, N�� 4714�� 5221�� 6542�� 6355 �� 4335�� 3429

millions mWh, Q �� 6�� 10�� 22�� 33�� 68�� 80

% generation steam, G�� 20%�� 38%�� 48%�� 58%�� 59%�� 68%

Source: Census of the Electric Power and Light Industry

With improved technology and new steam turbines, electricity output per worker rose.� The four main sources of power were combustion engines, steam engines, steam turbines, and hydroelectric generation.� The new technology utilizing steam turbines supplied 20% of horsepower in 1907 but by 1932 that percentage had more than tripled.� The share of hydroelectric power remained stable over the period.

Between 1911 and 1920, most states replaced local franchises with state regulated monopolies, a shift from locally governed competition to state regulated monopoly.� After 1920, industry output continued to grow but the number of firms decreased, and after 1927 the real price of electricity rose.�

Stigler and Friedland (S&F, 1962) study the period before the Federal Power Act of 1935 and examine the effect of regulation on electricity prices, differential pricing across customer classes, and prices of electricity stocks.� They conclude that regulation had no effect on electricity prices in 1922.� Comanor (1970) and DeAlessi (1974) point out that under the appropriate one tailed test the S&F regulation coefficient is significant at the 10% level, suggesting the opposite conclusion.

S&F examine the ratio of residential to industrial prices and predict that regulators would cater to the popularity of cross-subsidized or relatively low rates for residential consumers.� They uncover evidence of the opposite for both 1917 and 1937.� The ratio of residential to industrial prices was higher in the regulated states.� They conclude that regulation had no effect but might have concluded that industrial lobbies had more influence on the PSCs than residential groups.

Jarrell (1978) modifies the S&F analysis by separating �early� states that established commissions between 1912 and 1917.� Jarrell finds early states had lower prices and highest outputs, and concludes that the competition induced by local franchises induced producers to lobby for state monopoly regulation.

Jackson (1969) uses 1917-1950 data to estimate the more recent impacts of regulation, and concludes that regulation lowered the relative residential price using a specification similar to S&F.� Moore (1970, 1975) finds that state regulation resulted in a higher ratio during the 1950s and 1960s.� The conclusion is that influence of large industrial buyers on state PSCs solidified by the 1950s.

3.� Incentives and Local Franchises

The move to state regulation reduced regulatory negotiations, increased information asymmetries with regulators, and dispersed the effects of regulation.� State monopolies ended franchise fees for local governments, and the public paid costs of the PSCs.� Of the 40 states with PSCs in 1941, only 23 had a provision for the utilities to pay regulatory commission expenses (State Commission Jurisdiction, 1941).

The principal-agent problem underlies another motive for the industry to advocate state regulation as developed by Barnett and Sophocles (1997).� A regulated industry has incentive to distance itself from its regulator.� Local nonexclusive franchises would seem likely to keep price closer to the competitive level.� Kaserman and Mayo (1995) point out that state regulation involves an elected official, a legislative committee, and a regulatory commission staff.� With this increase in the number of principal-agent relationships, there is more opportunity for agents to substitute their own agendas for those of customers.� In contrast, local franchises would make customer wishes more prominent.

By expanding the scope of regulation from the local to the state level, the industry dispersed the effects of regulation over more customers.� This larger and more diverse customer base made it more difficult for customers to organize politically in opposition to regulatory rulings.� This, in turn, gave both regulators and regulated firms more discretion.� Similarly, Peltzman (1976) makes the point that the electric industry would now prefer federal to state regulation.

4.� Restructuring I: An Empirical Multi-Market Model

At the turn of the century, natural gas was a final product, providing lighting and a general substitute for electricity.� Natural gas was also an input in electricity generation.� The input of gas in electricity generation increased dramatically during this transition: 1.3 billion cubic feet in 1907, 20 billion in 1922, and 96 billion in 1932.� Further, by 1932 steam turbines generated over 60% of all electricity.�

The following multi-market system of stochastic equations captures these market interdependencies.� Two stage least squares estimates on the pooled data yield consistent unbiased estimators:

�� lnD = a₀ + a₁lnP_e + a₂lnY + a₂lnP_g +� a₄lnM + a₅lnN + a₆T + e₁�� (1)

�� lnS = b₀ + b₁lnP_e + b₂lnP_g + b₃lnP_c + b₄lnP_o + b₅lnF + b₆G + b₇lnH + e₂�� (2)

�� lnF = c₀ + c₁lnE + c₂R + e₃�� (3)

�� lnD_g = d₀ + d₁lnP_e + d₂lnP_g + d₃lnY + d₄lnM + d₅lnN + d₆T+ e₄�� (4)

�� lnS_g = e₀ + e₁lnP_g + e₅.�� (5)

Symbols in the model are:

�� D �� quantity of electricity demanded��

S �� quantity of electricity supplied��

P_e �� price of electricity��

Y�� manufacturing wage bill (proxy for aggregate income)��

P_g�� price of natural gas��

V�� manufacturing value added

N�� state population��

T �� year

P_c �� price of coal��

P_o �� price of oil

F �� number of electric firms ��

G �� % steam generation

H �� % hydro generation��

E �� electric industry revenue

R �� state PSC regulation dummy variable��

D_g �� quantity of gas demanded

S_g �� quantity of gas supplied��

The quantities of electricity demanded and supplied equal the quantity of output in market equilibrium, D_e = S_e = Q_e.� Price P_e is average revenue per kWh, reported in the data for 1927 and 1932 and calculated consistently for previous years.� To the extent that electricity was a substitute for gas in consumption, the relationship between its price P_g and the quantity of electricity demanded D would be positive in (1).� Aggregate income Y, the manufacturing wage bill by proxy, should increase demand if electricity is a normal good.� Industrial demand for electricity, represented by manufacturing value added V, would also raise demand.� Population N should increase demand, as should time T with the introduction of electric appliances during the period.

On the supply side, a higher price for the inputs of gas P_g, coal P_c, and oil input P_o should raise cost and reduce electricity supply S in (2).� The effect of the number of electric firms F on quantity supplied would depend on output per firm.� Variables on the percentage of steam generation G and hydroelectric generation H in (2) capture the introduction of these technologies.

The number of firms F is the endogenous variable in (3).� Electric industry profit should lead to entry, and industry revenue E is a proxy for profit.� State PSC regulation R is an exogenous political variable in the model that imposes entry barriers and should reduce the number of firms F.

Data for natural gas are from Mineral Resources of the United States.� A system of pipelines developed during the period from the major producing states:� Pennsylvania, West Virginia, Ohio, Texas, and Oklahoma.� In some states such as California, consumption equaled production.� For states without production, there is no reported price but the average price of neighboring states is a proxy for the price of gas.� For example, Mississippi reported no production or consumption in 1907 but Louisiana, Arkansas, Tennessee, and Alabama produced gas that was in principle available in Mississippi for no less than some average of these neighboring prices plus a transmission cost.� A similar procedure calculates a price for coal P_c and oil P_o in states without production.

The manufacturing wage bill Y is from Earnings of Factory Workers and the Statistical Abstract after 1929.� Manufacturing value added V and total state population N are also from the Statistical Abstract.

Dates of state PSC regulation from the NARUC Yearbook differ in a few cases from Stigler-Friedland (1962) and Jarrell (1978).� Both S&F and Jarrell assume regulation was effective three years following a PSC but they typically began after years of judicial debate.� S&F use 1914 as the first year for a state commission in Virginia but there had been a state commission since 1902.� Legislation creating an Illinois PSC passed in 1907 but implementation did not take place until 1913.� Municipalities did not idly lose a major source of revenue.� Shortly following establishment of the PSC in Illinois, municipal governments started the �Home Rule� movement to regain their lost local franchises as reviewed by Hughes (1983).� Given the high political profile of restructuring, the present study uses no time lag for the state regulation variable R.

5.� Empirical Results of the Multi-Market Model

Table 3 presents the model estimates.� The demand for electricity D in (1) is price inelastic, suggesting regulatory constraints were binding.� The price and quantity demanded rose over the estimation period but control variables should adjust for increased demand.� Without binding regulation the state monopolies would have charged higher prices, but the regulated price might have been higher than it would have been with competitive local franchises.��

�� Table 3.� Multimarket System, 1907-1932 (t-statistics)

�� (1)�� (2)�� (3)�� (4)�� (5)

lnD�� lnS�� lnF�� lnD_g�� lnS_g

lnP�� �� -0.923�� -4.379�� 3.046��

(-8.77)�� (-8.49)�� (4.39)��

lnY�� 0.218�� -1.756

(4.89)�� (-1.36)

lnP_g _�� -0.149�� 0.583�� -15.37�� 12.36

(-0.88)�� (0.54)�� (-3.14)�� (-2.83)

lnP_c�� -0.520

(-0.82)

lnP_o�� -0.836

(-2.03)

lnV�� 0.321�� 2.135

(7.74)�� (1.78)

lnF�� 0.008

(2.53)

lnN�� 0.223�� 7.185

(3.79)�� (4.22)

T�� 0.075�� 0.462

(15.8)�� (3.36)

G�� 0.154

(0.64)

H�� -3.542

(-5.09)

E�� 36.4

(3.32)

R�� -60.3

(-2.20)

Higher income Y increased demand, indicating electricity was a normal good.� The price of gas P_g did not affect demand, suggesting electricity was not an effective substitute for gas in consumption.� Manufacturing output V had a positive effect on demand. �Population N and time T increased demand.

On the supply side in (2), the price of electricity P_e had a negative effect on quantity supplied.� The trend toward regulated state monopolies during the period evidently undermined the economic relationship between price and output.�

Input prices of gas P_g and coal P_c had no effect on electricity supply in (2) but a higher price of oil P_o lowered supply.� More firms F raised supply.� The percentage of steam generation G had no effect on supply but increased hydro generation H reduced supply, suggesting customers paid the construction cost.

Electric industry revenue E had a positive effect on the number of firms F in (3).� Revenue E is a proxy for profit, and higher profit would attract firms to the industry.� State PSC regulation R lowered the number of firms, most likely promoting consolidation or mergers as it inhibited competition.

Regarding the demand for natural gas D_G in (4), the price of electricity P_e had a positive impact.� Even though electricity was not a substitute for gas in consumption, gas was a substitute for electricity.� Consumers were sensitive to the price of electricity, at the time newer and relatively expensive.� The coefficient on the price of gas P_g in (4) indicates highly price elastic demand.� Higher income Y lowers demand for gas suggesting it was an inferior good (a marginally insignificant effect).� The demand for gas increased with both population N and time T.� The price of gas P_ghad a negative effect on the quantity of gas supplied S_g in (5) due in part to the states reporting no production and the imputed positive price.

Previous studies have reported inconclusive evidence on the effect of state regulation on the price of electricity.� Price was falling during the early period but the decline stopped at about the time a substantial number of states had regulatory commissions.� Increased regulation lowered the number of firms, reducing supply.� Solving (1) and (2) in Table 3 for lnP, the elasticity of price with respect to the number of firms is dlnP_e/dlnF = -0.002.� Given dlnF/dR = -60.3 from (3), it follows that dlnP_e/dR = .061.� State PSC regulation led to a higher price of electricity.

It is possible to calculate the entire set of price elasticities in a similar fashion.� In equilibrium, lnD = lnS in (1) and (2).� Dropping insignificant coefficients and solving for lnP_e,�

lnP_e = .173 lnP_g + .045 lnY + .067 lnV - .002 lnF + .046 lnN + .015T + .730H.�� (6)

Every 1% increase in the price of gas P_g raised the price of electricity by only 0.173%.� Elasticities of price P_e with respect to income Y, manufacturing value added V, number of firms F, and population N are very small.

6.� The Effects of Restructuring on Cost and Profit

The present section examines the effect of regulation on cost and profit using data from 1907 to 1922.� After 1922, the Department of Census quit reporting �expenses� perhaps due to pressure from the evolving monopolies.� There might have been an assumption that revenue and cost would be equal for rate-of-return regulated firms.� Of the 40 states that had regulated monopolies by 1932, all but two had made the transition by 1922.�

Let C_e represent the average cost (price) of producing one kWh of electricity, calculated as total expenses divided by output.� Average output per firm is q.� Table 4 presents an estimate of the cost function at the firm level,

lnC_e = f₀ + f₁lnP_g + f₂lnP_c+ f₃lnP_o + f₄lnq + f₅G + f₆H + f₇R + f₈T + e₇.�� (7)

Table 4.� Cost and Profit Functions, 1907-1922

�� lnC�� lnp

lnP_e�� 1.065

�� (10.3)

lnP_g�� 0.119�� -0.049

(1.67)�� (-0.78)

lnP_c�� 0.618�� 0.004

(0.43)�� (0.03)

lnP_o�� 0.511�� 0.096

(0.59)�� (1.27)

lnq�� -0.254�� 1.050

(-7.84)�� (28.4)

G�� -0.087�� -0.256

(-0.55)�� (-1.81)

H�� -1.073�� 0.394

(-8.79)�� (2.77)

R�� 0.189�� -0.125

(2.42)�� (-1.79)

T�� -0.027�� -0.034

(-3.14)�� (-3.87)

An increase in the price of gas P_g raises cost C_e, while prices of coal P_c and oil P_o have no effect.� Cost C_e declines with output per firm q, evidence of decreasing cost at the firm level.�

A higher percentage of hydro production H lowers cost C_e.� Its positive effect on price in (2) suggests that regulated monopolies enjoyed lower costs but charged higher prices when they moved to hydro generation.� Regulation R raises cost due to the lack of competitive pressure and the incentive to overstate cost to regulators.� Cost C_edeclines over time T.

Profit p_e is income less expense, and the following profit function focuses on the effect of regulation R on profit,

�� lnp_e = g₀ + g₁lnP + g₂lnP_g+ g₃lnP_c + g₄lnP_o + g₅lnq + g₆G + g₇H + g₈R + g₉T + e. �� (8)

The estimate of (8) is also in Table 4.� A higher price of electricity P_e raised profit p_e, and by about the same percentage.� Input prices P_g, P_c, and P_o have no effect on profit p_e, suggesting electric customers paid fuel costs.

Larger firms have higher profit, every 1% increase in output per firm q resulting in slightly more than 1% increased profit p_e.� Firm size q does not affect cost in (7) and must have stimulated revenue.� The consolidation and mergers of restructuring paid dividends.�

Increased percentage use of steam plants G lowered profit p_e slightly even though costs in (7) are not affected.� Firms were evidently not able to raise revenue with the increased use of steam.� Increased percentage hydro generation H raised profit p_e in (8) and lowered cost in (7).� Over time T, profit p_e fell.

The negative coefficient for regulation R in (8) might suggest that it was successful in controlling profit p_e.� Regulated monopolies, however, have the incentive to overstate costs and report low profit.� Combining the results for R in Tables 4 and 5 indicates that regulation led to higher cost and lower profit.� Higher costs could have been due to relatively high worker perks, overcapitalization, or inefficiency of the new state monopolies.

�� Table 5.� Determinants of Profit, pre- and post-1912

lnP_e�� 0.978�� lnPD�� 0.306

(6.89)�� (1.33)

lnP_g�� -0.012�� lnP_gD �� -0.064

(-0.18)�� (-0.47)

lnP_c�� -0.084�� lnP_cD�� 0.207

(-0.49)�� (0.65)

lnP_o�� 0.207�� lnP_oD�� -0.088

(2.02)�� (-0.57)

lnq�� 0.980�� lnqD �� 0.118

�� (19.4)�� (1.49)

M�� -0.721�� MD�� 0.555

(-3.14)�� (1.93)

H�� 0.279�� HD�� 0.392

(1.37)�� (1.27)

R�� -0.249�� RD�� 0.168

(-2.62)�� (1.19)

To examine the effect of regulation on profit over time, split the 1907-1922 data into two subsets with the break at 1912 corresponding roughly to what Jarrell (1978) calls early and late regulation.� Only 18 states had commissions in 1912 but there were 30 by 1917, and Jarrell uses 1917 as the break date.� A dummy variable D for the profit function in (8), D = 0 in 1907 or 1912 and D = 1 otherwise, is interacted with each term in (8) and reported in Table 5.

Price had a strong effect on profit p_e up to 1912.� Prices of gas P_gand coal P_chad no effects on profit p_e during either period, evidence electric customers paid fuel costs regardless of industry structure.� Competition ensured lower fuel costs resulted in to lower electricity prices.

A higher price of oil P_o increased profit p_e for electricity producers before 1912, suggesting that electricity and oil were substitutes in consumption.� Output per firm q had a strong positive effect on profit during the early period, again suggesting that restructuring paid dividends.�

The negative effect of percentage steam generation G on profit p_e occurred before 1912.� The new technology was not profitable during the more competitive era.� Competition may have encouraged the new technology but firms were not able to translate that technology into higher profits.

Increased percentage hydro generation H, however, raised profit p_e during the competitive early period.� Higher profit is consistent with the lower cost in (7).� However, over the entire period in the multi-market model, increased hydro generation resulted in lower cost and higher electricity prices.� Hydro generation was cost effective but consumers did not benefit over the entire period, perhaps due to monopoly pricing.

There is a negative relationship between regulation R and profit p_e during the competitive period up to 1912, but regulation encouraged firms to report lower profit.� Firms lobbying for a monopoly franchise would want to appear unprofitable.� The coefficient of R for the late period is the sum of coefficients of R and RD:� .249 + 0.168 = -0.081.� The t-statistic is calculated by the dividing the coefficient estimate by its standard error [var(G) + var(GD) + 2cov(G, GD)]² = 0.105.� The insignificant t-statistic is -0.762.� After 1917, regulation did not affect profit.�

7.� Conclusion

In the early years of the US electric industry, a successful industry lobby led to restructuring from local franchises to state regulated monopolies.� The present study finds that this first step in restructuring reduced the number of firms, raised, cost, and raised the price of electricity.� Regulation had less effect on profit as the monopolies matured.� The present results support the theory that the new monopolies captured the regulators.�

At present, there is an opposite move of sorts, from regulated state monopolies toward retail competition.� Reversing the results of the present study, the implications are more firms, lower cost, and lower price.� There are complicating issues and historical differences from the earlier restructuring, including lower energy consumption shares, higher per capita consumption, better technology, telecommunication, more local pollution, increased awareness of pollution, highly organized interest groups, increased government involvement at various levels, and federally regulated interstate wholesale competition.� Still, it is safe to say that a move away from regulated state monopolies toward increased competition will increase the number of firms, lower costs, and lower prices in the electric industry.��

References

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�

The First Step in Restructuring the US Electric Industry

1.� A Competitive Electric Industry

��������������� Table 1.� Dates of State Regulatory Commissions

Year��������� State������������������

1889��������� MA���������������������

1902��������� VA